Book SummaryNaked Economics, by Charles J. Wheelan

1-Page Summary1-Page Book Summary of Naked Economics

Economics is the study of how we allocate resources—not only tangible resources like food, clothing, and money, but also intangibles like time, effort, and knowledge. To understand this process, economists begin by examining incentives: the driving forces behind our decisions. By understanding how we respond to incentives and the psychological instincts that steer us, we can better understand how market forces work and how governments and firms can use incentives to foster a healthy economy.

In Naked Economics, bestselling author Charles Wheelan strips away the complexity from some of the most powerful theories in economics, allowing readers with little or no background in the subject to understand many of the field’s most fundamental concepts. He skips over the more technical, mathematics-based aspects of the discipline and concentrates instead on the logical pieces of how and why people behave in certain ways, how markets function, and how governments can design incentive systems that encourage healthy economies.

We’ll structure our discussions by walking through different aspects of markets one by one:

• We’ll first explore what a market is and how a market works.
• We’ll then go into more depth about how incentives drive markets and how governments can influence markets as well.
• Then we’ll discuss how financial markets work.
• We’ll also look at how economies of different countries are measured and compared, how recessions happen, and how governments can work with financial markets to manage recessions.
• We’ll finish by exploring international markets. We’ll look at how currencies work and how markets can pull developing countries out of poverty.

Introduction to Markets

Let’s start by exploring some basic economic concepts:

• Markets, and what they are
• Prices, and how they reflect supply and demand
• Incentives, and how people respond to them

Markets

A market is a collection of billions of separate transactions that form a complex economy in which people can earn and spend money to fund their lives. A capitalist market allocates resources by matching supply with demand, thereby directing resources to where they will be most productive. In doing so, a market improves society by increasing opportunities for people to make income and increasing the variety of goods available to consumers.

Prices Reflect Supply and Demand

When a sale is made, firms and individuals connect and maximize their utility against each other. “Utility” can be thought of as happiness, and maximizing it means making yourself as well-off as possible. In a sale, firms look to make as much money as possible, while individuals look to satisfy a need or desire by purchasing something.

In a capitalist economy, meeting points between sellers and buyers are regulated by prices, which reflect the supply and demand for any item on sale: how much of something is available and how much people want to buy it.

When sellers and buyers settle on a price that reflects a balance between supply and demand, they’ve set the market price for that particular thing, where its price encourages enough demand from buyers to generate an acceptable amount of profit for the seller. There is often a complex process involved in arriving at that price: In general, when prices increase, fewer people buy that thing, so the demand drops relative to its supply. If demand drops enough, vendors respond by lowering the price. But when the price drops, people start buying that thing again, which increases demand, which in turn increases prices again.

People Respond to Incentives

Self-interested incentives power the economy. Firms produce goods in order to make money for themselves, and people work to earn an income for themselves. In general, such incentives help the economy work well—in the pursuit of personal income, people and firms produce goods and services that benefit others. However, there are situations where incentives can cause problems:

• The principal-agent problem: When a company (a principal) employs someone (an agent), they often have differing motivations. The principal wants to make money off their customers, but the agent might want to make money off the company (over and above a salary), ultimately harming business. For example, CEOs are motivated by personal rewards to do things like engineer corporate mergers, which lead to fame and status for the CEO, but very often don’t add value to the companies involved.
• Communal resources: Communal resources are finite resources of which everyone uses a piece, but no one in particular owns—such as fish in the ocean. Often, in markets based on communal resources, people have incentives to cheat the system and acquire as much of the resource as they can before others do. This usually leads to the resource being depleted, which harms everyone. Typically, the only solution to problems with communal markets is governmental regulation ensuring that no one party is able to take more than their fair share.
• Poorly designed regulations: If lawmakers try to encourage good behavior through regulations, they can worsen the initial problems if the regulations don’t properly account for how people will respond to incentives. For example, a law intended to reduce the amount of smog in Mexico City imposed restrictions on which cars could drive on which days, tracked through license plates. In response, instead of driving less, people simply bought second cars with different license plates, resulting in more cars on the roads. Lawmakers can prevent this kind of regulation-skirting by imposing laws with broad scopes that are harder to evade—such as fees that all cars have to pay within a city center, regardless of their license plates.

Government’s Role in Markets

A government makes a capitalist market possible. Though many people, including many politicians, talk about how much...

Naked Economics Summary Introduction

Economics is the study of how we allocate resources—not only tangible resources like food, clothing, and money, but also intangibles like time, effort, and knowledge. To understand this process, economists begin by examining incentives: the driving forces behind our decisions. This study makes up the field of behavioral economics, a relatively recent branch of economics, and one of the most applicable to our everyday lives.

By understanding the psychological instincts that steer us and how we respond to incentives, we can better understand how market forces work and make more informed decisions about how to spend or use our own resources. Additionally, governments...

Naked Economics Summary Chapters 1-2: Introduction to Markets

A market is essentially a collection of billions of separate transactions that form a complex economy in which people can earn and spend money to fund their lives. A capitalist market functions cohesively not because a centralized authority tells it what to do, but because each transaction works together efficiently. The paradox of the market is that while individuals use the market to increase their own individual well-being, in the process, they increase everyone else’s well-being also.

In this chapter, we’ll explore some basic ideas underpinning capitalist markets:

• The market allocates resources
• The market improves society
• Individual incentives drive the market

The Market Allocates Resources

A capitalist market is essentially a way to allocate resources. Because there’s a finite supply of anything that’s worth having—almond butter, clean water, spin classes, computer repair-people—we are faced with a basic problem of how to determine fairly who gets what, how much of it they get, and at what price they get it. Instead of determining these things through a centralized authority who doles out resources (as in a communist economy), a market allows...

Shortform Exercise: Examine Communal Resources

Communal resources are finite resources of which everyone uses a piece, but no one in particular owns—such as fish in the ocean. Systems based on such resources distort incentives because personal incentives rarely align with the incentives of the larger group.

Describe a time you operated in a market based on communal resources. (This doesn’t have to be a traditional, capitalist market—did you ever divide up communal chores between roommates or pitch into a project at work that involved many people but had no clear leadership?)

Naked Economics Summary Chapters 3, 4, and 8: Government’s Role in Markets

Now that we’ve explored some basic concepts of economics, let’s look at the role governments play in markets.

A government makes a capitalist market possible. Though people, including many politicians, sometimes speculate about how much better the market could operate if there were little or no government control of markets (or even society), the truth is, countries without strong governments have almost non-existent markets in which it’s difficult to conduct even simple transactions. For example, businesses find it almost impossible to operate in Somalia, where a lack of government means there’s little infrastructure or protection against criminals.

In this chapter, we’ll explore the different ways a government can facilitate a functioning market economy. We’ll also explore the ways it can destroy one: Government intervention in the economy isn’t always beneficial.

A Government Enforces Laws

The most essential thing a government does to benefit the economy is provide laws and infrastructure that allow businesses to conduct transactions. Without a set of rules that everyone involved in a market agrees to, and which can be enforced, a market can’t smoothly...

Naked Economics Summary Chapters 5-6: Information and Human Capital

The next elements of economics we’ll discuss are information and human capital: Any economy is driven in large part by these two major influences. In these two chapters, we’ll explore how each element affects individuals, businesses, and the functioning of an economy.

Information

Information, and who has access to it, has an outsized influence on how smoothly an economy runs. A free flow of information allows for easy and smart transactions. Information imbalances—when one party knows more than the other party in a transaction—put one party at a disadvantage to the other: Markets generally favor the party who has more information.

To counter information imbalances, people and businesses will try to glean information about what they’re buying from indirect sources. This process affects how people and businesses interact with each other.

Information and Individuals

You’re often at a disadvantage when you make a purchase because the business selling you a product knows more about its quality than you do. You won’t be able to fully judge its quality until after you’ve purchased it—for example, you won’t know if you like a burger until after you’ve...

Shortform Exercise: Examine Your Human Capital

Your human capital is the sum of what makes you valuable and marketable as an individual—your intelligence, athletic ability, education, and work experience, as well as your charisma, work ethic, creativity, and honesty.

Think about your human capital. What personal traits set you apart from other people and allow you to earn an income?

Shortform Exercise: Exchange Information

Information, and who has access to it, has an outsized influence on how smoothly an economy runs. A free flow of information allows for easy and smart transactions, while information imbalances put one party at a disadvantage to the other.

Think of a time when you had to make a purchasing decision but didn’t have a lot of information about the item or service you were buying. How did you try to obtain information that could help you? Did the information influence your purchasing decision? (For instance, did you look at online reviews for the item or service, find those reviews were negative, and decide not to buy the item?)

Naked Economics Summary Chapter 7: Financial Markets

We’ll now turn our attention to financial markets: markets specifically designed for moving and managing money. This includes stock and bond markets as well as insurance markets. What other markets do for tangible goods, financial markets do for capital—essentially, they direct it to where it can be the most productive, which, in general, is where it’s earning the highest return.

Financial markets service some basic human needs, which we’ll explore below. We’ll then discuss a common misbelief about financial markets, which is that you can “get rich quick” using them. Finally, we’ll briefly look at some basic investing guidelines.

Financial Markets Serve Four Needs

Financial markets satisfy four basic needs that people have in an economy:

1. They allow people to raise money.
2. They allow people to store, protect, and profit from excess money.
3. They insure people against risk.
4. They allow people to speculate.

1. Raising Money

The most basic use of financial markets is to allow us to raise capital, either by borrowing money or by selling stocks. In either case, financial markets allow us to raise money for things we couldn’t afford otherwise—for a...

Shortform Exercise: Get Rich Slow

Financial markets’ reputation as a way to “get rich quick” is misleading, because first, all information you can make trading decisions with is available to the public, and second, while you’re trying to maximize your utility (your happiness), everyone else is doing the same.

Describe a time you used financial markets to invest or speculate in a way that you hoped would earn you a quick return. What was the ultimate result of your speculation?

Naked Economics Summary Chapters 9-10: Measuring and Managing Recessions

Sometimes, an economy functions well: It grows at a healthy rate that allows many people to earn a good living. But sometimes, it suffers a period of stagnation or contraction, when people find it harder to survive or to thrive within the market. Every economy generally goes through periods of growth punctuated by periods of recession in what economists call the “business cycle.”

In these chapters, we’ll explore how economists measure the health of an economy, what causes an economy to fall into recessions, and how governments can respond to recessions to fix them (or better yet, to prevent them).

Gross Domestic Product (GDP)

In order to properly evaluate the strength of an economy, economists must figure out how to measure economies in a way that allows for effective comparison. There are several markers of economic health that they look at, but the primary one is an economy’s gross domestic product, or GDP. GDP summarizes the value of all the goods and services an economy produces. It’s the number that people generally refer to when they talk about a country’s growth: If you say the U.S. grew 3 percent this year, what you mean is that the U.S. produced 3...

Naked Economics Summary Chapter 11: International Currencies

The concepts we’ve reviewed so far relate to how an economy functions in general, and typically within the borders of one particular country. We’ll now look at how people, firms, and governments of different countries can interact with each other globally in an international market, buying and selling not only goods and services but also currencies.

International markets operate similarly to domestic markets, except on a global scale. The global nature of the international market adds complexity to business transactions, not only because of the logistics of buying and selling goods and services from far-away regions, but also because different countries have different rules, regulations, taxes, and currencies.

A currency is the unit of money a country uses to conduct its business. Different countries have different currencies—for example, the United States has the dollar, Mexico has the peso, and Japan has the yen. Each country also has its own governmental institutions that create and manage its currencies.

In this chapter we’ll examine currencies, and how the international market uses them to function, covering:

• What a currency represents (purchasing power) and...

Naked Economics Summary Chapters 12-13: International Trade

Now that we’ve discussed currencies, we’ll look at international trade in general, and how it can be used to improve living standards around the world. We’ll also look at what countries generally need to thrive economically.

To a large extent, the world is economically interdependent. Exports have increased from 8 percent of global GDP in 1950 to 25 percent today, meaning that countries are trading many more of their goods and services abroad. The increase in international trade is often called globalization.

Overall, international trade makes all the countries involved richer and raises their standards of living, be they rich or poor to start with. It does so by:

• Lowering the cost of goods, which has the same practical effect as increasing people’s incomes
• Increasing access to a variety of goods
• Increasing productivity through specialization: Trade frees people up to focus their efforts where they can be most effective. For example, if you buy a car that someone else built rather than building a car for yourself, you will not only get a better car, but you will have time to do other things that you’re better skilled at.

Trade Helps Poor Countries...

Shortform Exercise: Engage in Smart Social Advocacy

Sometimes, rich-world social advocates object to what they see as negative effects of globalization that the poor world suffers and try to impose regulations intended to counter these ills. Unfortunately, though well-intended, these “solutions” often make problems worse, not better.

Describe a time you boycotted goods from a developing country, or saw others doing so, because of social advocacy. (For example, did you ever avoid a product because of news about poor factory conditions or a bad environmental record?)

Naked Economics Summary Epilogue: Looking Forward

There are many different flavors of capitalism: Some allow for more of a free-for-all, while others are more concerned with minimizing capitalism’s drawbacks. In each country, people must decide for themselves what kind of market they want, weighing their priorities and voting for governments that support those priorities. In doing so, governments and their people must consider several basic questions:

How will we maximize our utility? In general, as a population’s wages go up, people start to work longer hours. At some point, though, people start to decide that time is more important than additional money, and they start to work fewer hours. Each country—and each person within it—must decide for themselves where they want to draw that line: For example, will we end up working 50 hours a week and earning a lot of income, or will we decide we prefer to work 30 hours a week and enjoy what we can of our lesser income? Will we derive more utility (happiness) from listening to vintage records or walking in the park than working so that we can buy more records and a house closer to the park?

How do we slice up the pie? Some countries, like the United States, value a...

Shortform Exercise: Maximize Your Utility

The first assumption of economics is that people will do what they can to maximize their utility. “Utility” can be thought of as happiness, and maximizing it means making yourself as well-off as possible.

At what level of income will you be happy to spend more time outside of work, enjoying the fruits of your labor rather than pursuing more income? What specific factors will determine when your income becomes sufficient for you?